Fire Grandpa! Hire Junior!

When I first came to London to seek my fortune, I was taken out to lunch by a family friend with about three decades more experience than I. She cheerfully told me that I wasn't worth the salary that my brand new job was paying me. She was right, as it happens, since I was an extraordinarily bad management consultant, but she was betting against the odds. The typical young person is worth more than he or she is paid. Young people who feel that the odds are stacked against them turn out to be right.

Older workers, on the other hand, tend to be overpaid relative to what they produce. This is not because they are less productive than the young—although many important skills do start to decline at the age of 30, or even earlier—but because they are paid so much more. Decades of economic studies have produced the conclusion that average wages increase with age almost until retirement, yet average productivity seems to be flat or perhaps even declining after the age of 50. (The studies are not unanimous, because productivity is very hard to measure, and, of course, the averages hide huge variations from job to job and person to person). Perhaps my plain-speaking mentor was paid five times as much as I was, but if she was only three times as productive, then I was the bargain-basement employee.

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I can look forward to a big bag of hate mail for reporting on this research, but I think that subconsciously we know it's true, because we tend to fret about the problem of age discrimination in the workplace. Age discrimination is much more of a risk if older workers are indeed paid well relative to young ones: It means older people are the ones managers want to sack to save a bit of cash. The British government is introducing new, tougher rules against age discrimination in October; if older workers tended to be worth much more than they were paid, it would scarcely be necessary. And overpayment of older workers seems to be an international phenomenon.

This is a puzzle. Young workers can rightly grumble that they are paid a pittance for doing valuable work. Older workers also have good cause to worry: They are being subsidized, but subsidies are expensive, and that means they have every reason to fear the sack. Wouldn't it make more sense for young workers to be paid a bit more, old workers to be paid a bit less, nobody to feel exploited, and nobody to fear premature retirement?

The income of self-employed people does tend to track their productivity more closely, which suggests that the odd relationship of underpaying and then overpaying is a corporate phenomenon. The intuitive explanation is that this is some kind of corporate welfarism: After all, a 50-year-old middle-manager with one kid in private school and another at Harvard needs all the financial help he can get. Twenty-two-year-old wunderkinds are perhaps happy when they realize they can buy all the beer they want.

Economists have little patience with this kind of story. Corporations keen to recruit the best are unlikely to sit back and let competitors poach the most talented graduates with a few sign-on freebies, so pay for young workers should reflect their performance. Meanwhile, few people believe that companies are really in the business of subsidizing their employees, at least not until they reach the board.

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Economists tend to prefer the insights of Edward Lazear, who suggested that young employees are often encouraged to perform by the promise of a cushy cruise toward retirement. Lazear realized that it is hard to measure and reward performance directly, but underpaying the young and overpaying the old tends to encourage effort. As long as there is some risk that shirkers will be sacked, workers will beaver away knowing that if they can hold onto their jobs, it will all be worthwhile.

Lazear also suggested that the boss's fat-cat salary is designed to motivate the lean and hungry young junior executives beneath him and has very little connection to his own performance. (Much is explained.)

This is all fine in theory, but not so great if the firm goes bankrupt or decides under new competitive pressures that the "job for life" system has to go. But seniority wages are probably here to stay as long as it is hard to reward good performance instantly and accurately.

Meanwhile, Professor Lazear has in his late 50s been named chairman of President Bush's Council of Economic Advisers. It is a difficult job; we shall see whether his performance exceeds his pay.

The Undercover Economist appears on Saturdays in the Financial Times Magazine.